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m n iic n s c ©

July 20, 1973

The dollar strengthened in world
markets last week, amid news of an
expanded Federal Reserve "swap"
line and rumors (later officially con­
firmed) of central-bank intervention
to support the market. That im­
provement, however, came after
two months of almost steady de­
cline. Following the two devalua­
tions of December 1971 and Feb­
ruary 1973, the dollar was effectively
devalued by 15.2 percent from the
pre-Smithsonian level.* After fluc­
tuating for several months, it weak­
ened again in May and June, so that
effective devaluation amounted to
2 1.3 percent by July 6. Then, a week
later, the figure was back up to 19.5
percent as the dollar improved.
A number of factors were involved
in the declining fortunes of the
dollar these past several months.
Foreigners seemed to be increas­
ingly worried during this period
about the nation's political and
economic stability— in particular, by
the accelerating American inflation.
Other factors included the tight­
ening of monetary and fiscal poli­
cies abroad, and a sharp speculative
run-up in the price of gold.
Under these circumstances, be­
cause of the many political and
financial issues that are still unre­
solved, the present system of flex­
ible exchange rates undoubtedly
will continue. However, centralbank intervention in the market is a
possibility from time to time. To this

end, the Federal Reserve an­
nounced last week a $6.25-billion
expansion of its swap network—the
reciprocal currency arrangements
which the U.S. could utilize to
support the dollar if it so desired.
Growth of swaps
The swap-line between the Federal
Reserve and other central banks
was developed in 1962 and substan­
tially expanded through the years
until 1971, in an era when fixed
exchange rates were the dominant
mode of international transaction,
and the dollar was the dominant
intervention currency in the for­
eign-exchange market. It was de­
signed to facilitate foreign centralbank maintenance of the fixed-ex­
change rate regime, by giving the
Federal Reserve the option of pro­
viding a temporary exchange guar­
antee for excess dollar holdings of
foreign central banks, while mini­
mizing their claims on U.S. gold
These lines of credit were made
deliberately short (90 days with a
maximum of three renewals) be­
cause they were intended to be
used only to meet temporary sur­
pluses of dollars in the hands of
foreign central banks. Intermediateterm dollar surpluses were to be
handled via other instruments—
and, of course, excessive long-term
acquisition of dollars was to be
handled by an official change in the
exchange rate.

*Dollar devaluation is com puted on the basis of the exchange rate between the dollar and
the currencies of the eleven countries which have the largest trade with the United States.
The base period for the computation is May 1970; thus, the floating of the Canadian dollar
. since June 1970 is included in the computation.
Digitized for F R A S E R
(continued on page 2)

F s d e m



In this fixed-exchange rate era, the
Federal Reserve did not normally
intervene in the foreign-exchange
market. Its role was to maintain a
fixed value of dollars in terms of
gold while all other central banks
maintained a fixed rate between
their national currencies and the
dollar. Thus, the swap network was
only used as a vehicle to facilitate
foreign central bank intervention in
the foreign-exchange market, that
is, provide an exchange guarantee
in lieu of their conversion of excess
dollars into our gold holdings. It
was not a source of Federal Reserve
intervention in the U.S. market.
When President Nixon announced
suspension of gold convertibility in
August 1971, the Federal Reserve
simultaneously suspended all fur­
ther active use of the swap-lines.
With a single exception early this
year, there have been no new swap
drawings. The suspension of swap
drawings was a natural develop­
ment in our program of encour­
aging foreign central banks to set
new and more realistic exchange
rates rather than encouraging them
to maintain the old rates.
Appropriate rate?
Last week's decision to expand the
swap network— reinforced by the
later official announcement of di­
rect Federal Reserve intervention in
the foreign-exchange market—
represents a change in the August
1971 policy. The question arises as
to what induced this change.
Knowledgeable observers would
suggest the following. The approD ig e if f s / F s a s e B S 'ra te f o r * " * c u r 

rency is that which leads to equilib­
rium in the balance of payments.
There is a strong feeling that the
continued devaluation of the dollar
in the private foreign-exchange
market is making the dollar under­
valued; moving the dollar away
from the exchange rate which
would provide balance-of-payments
The reason the dollar is under­
valued on a balance-of-payments
criteria is that in its role as an
international currency there has
been a major stock adjustment oc­
curring. The devaluation of the dol­
lar, which was necessary to elimi­
nate its previous overvalued
position, has simultaneously led to
a reduction in the demand for dol­
lars as a medium for holding inter­
national assets. As the private
market diversifies its portfolio of
international assets to contain less
dollars and more of other curren­
cies, the value of the dollar has
been forced below its balance-ofpayments equilibrium value.
It can be argued, under these cir­
cumstances, that the market is not
performing its proper function and
that it is necessary for the central
bank to intervene to bring the ex­
change rate into line with long-run
balance-of-payments equilibrium.
In the current case, that would
mean some appreciation of the dol­
lar, presumably by central-bank in­
For intervention
The strongest argument for inter­
vening in the market is the fact that

the dollar is clearly undervalued for
balance-of-payments purposes.
Conversely, most European curren­
cies and the Japanese yen are over­
valued. There is a long history (most
recently with respect to the U.S.)
where countries with overvalued
currencies have tended to move
toward protectionist trade legisla­
tion. This is designed to protect
export and import-competing in­
dustries from the "unfair" competi­
tive advantages which those for­
eigners would now enjoy. The
natural constituency in favor of free
trade rapidly diminishes when the
number of industries which benefit
from world trade is shrinking.
It can also be argued that if the
present exchange-rate trend of a
devaluing dollar continues, we will
not only get no trade concessions
from the Europeans and Japan but
will most probably face new trade re­
strictions on our exports. This would
be a major blow to the trade liberali­
zation moves of the last generation.
Against intervention
On the other hand, we have no idea
of the amount of intervention
needed to reverse the devaluation
of the dollar. It must be remem­
bered that there are few capital
controls on U.S. residents, so that
we face the prospect of dealing not
only with portfolio diversification of
private nonresidents but also of all
U.S. residents who may choose to re­
duce their dollar balances and increase
their foreign-currency balances.
In addition, other central banks
DigitizIdfOPFRASER themselves over

whelmed in their attempts to main­
tain exchange rates that the market
does not believe viable. The classic
case was that of the Bank of France,
which in mid-March 1973 planned
to stay open with a fixed-exchange
rate when all other European banks
had gone to a float. It was forced to
hastily close its window in 45 min­
utes after it had taken in excess of
$1 billion. There is no technical rea­
son to assume that any other central
bank can be any more successful
in the foreign-exchange market.
Role for swaps
Even if one were to accept the
argument that Federal Reserve in­
tervention in the exchange market
is both proper and effective at the
present time, the swap line is prob­
ably not the appropriate method to
mobilize the resources for such
intervention. It is unlikely that the
current undervaluation of the dollar
is a temporary phenomena, and the
swap line was designed as a short­
term facility to meet only temporary
What then is the proper role of
swaps? They could be utilized to
prevent "disorderly market condi­
tions" when and if they occur. This
can be defined as roughly the for­
eign-exchange equivalent of a do­
mestic "credit crunch" where there
is no price at which transactions can
be conducted. In this very special­
ized case, private markets could be
considered as having at least tem­
porarily broken down, so that the
steadying hand of the central bank
would be both desirable and wel­
Michael Reran

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(Dollar amounts in m illions)

Loans adjusted and investments *
Loans adjusted— total*
Com m ercial and industrial
Real estate
Consum er instalment
U .S. Treasury securities
O ther securities
Deposits (less cash items)— total*
Demand deposits adjusted
U.S. Governm ent deposits
Tim e deposits— total*
O ther time I.P.C.
State and political subdivisions
(Large negotiable CD 's)

Weekly Averages
of Daily Figures

Am ount
7 / 4 / 73

6 / 27 / 73


+ 444
+ 341
+ 8
+ 73
+ 41
- 45
+ 148
+ 19
-1 8 5
- 47
-1 6 2
+ 56
+ 28
-2 4 8
- 31

Change from
year ago




Selected Assets and Liabilities
Large Commercial Banks



+ 15.69
+ 18.98
+ 20.61
+ 19.19
- 8.64
+ 5.27
+ 12.78
+ 4.53
+ 17.54
+ 16.74
- 0.73
+ 33.42
+ 18.57
+ 87.26

W eek ended
7 / 4 / 73

W eek ended
6 / 27 / 73

Com parable
year-ago period

- 88

-1 1 3


+ 577

+ 808


-2 7 7

+ 168


Member Bank Reserve Position
Excess reserves
Net free (+ ) / Net borrowed ( - )


Federal Funds— Seven Large Banks
Interbank Federal funds transactions
Net purchases (+ )/ Net sales ( - )
Transactions: U.S. securities dealers
Net loans (+ ) / Net borrowings ( - )


*lncludes items not shown separately.

Information on this and other publications can be obtained by calling or writing the Admin­
istrative Services Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San
Francisco, California 94120. Phone (415) 397-1137. Opinions expressed in this newsletter
Digitized for F R ^ g E ^
necessarily reflect the views of the management of the Federal Reserve Bank of
http://fraser.stloui»fedrorg/i sco nor of the Board of Governors of the Federal Reserve System.
Federal Reserve Bank of St. Louis